How to Integrate a Multifunctional Balanced Risk Strategy into Your Portfolio

The 60/40 stock/bond portfolio model has been the primary balanced investment approach for decades. Prior to 2022, a 40-year bond bull market created an environment where bonds buffered the losses during equity bear markets. Cracks started to form in 2018, and the approach suffered significantly in 2022, leading to the worst year on record for the 60/40 portfolio going back to the 1930’s.

Regardless of whether bonds return as a reliable defensive investment, we believe there is a better approach that has been utilized by sophisticated institutional investors for decades, an approach relying on Nobel Prize Laureate Harry Markowitz’s efficient frontier. We refer to this approach as a balanced risk strategy (or hybrid strategy), which integrates multiple uncorrelated investment approaches into one product. In this report, we provide historical analysis for a sample balanced risk strategy to highlight the benefits and to provide some context on how to think about integrating such a strategy into a portfolio. A balanced risk strategy tends to set the efficient frontier and is one where a portfolio optimizer may tell you that it would be best to skip everything else and go 100% into that fund.

Balanced risk strategies come in various formats. Since a 60/40 stock/bond portfolio has historically served as a generic basis of a balanced portfolio, we started there.

The example balanced risk strategy used in this report provides the following exposure: 60% exposure to the S&P 500 Index, 40% to Treasurys (Bloomberg US Treasury TR Index), and 100% exposure to the SG CTA Trend Index (60/40/100 Strategy). For investors that hold a traditional 60/40 stock/bond, they can simply reduce the stocks and bonds on a pro rata basis, add the balanced risk strategy, and then get back the same stock/bond exposure they had to sell to access the hybrid strategy. But now, they also have a alternative overlay.

Easier Integration. Investors don’t have to sacrifice traditional asset class exposure to get exposure to integrate alternative investments.

Offense + Defense. Can play both offense and defense which means it can contribute to returns in various market environments (versus just weathering the storm), making it easier for investors to stay disciplined and not sell at an adverse time.

Leveraging Modern Portfolio Theory. By combining several strategies with low correlation to each other in one portfolio, the potential returns of a balanced risk strategy can be enhanced at a given level of risk, and the probability of a negative year can decrease.

More Consistent Returns. % Positive Rolling Return Periods:

Data source: Bloomberg LP and Catalyst Capital Advisors LLC. Based on monthly return data from 12/31/1999 to 8/31/2024.

Start with the efficient frontier. An efficient frontier is the resulting plot of the returns of a portfolio on the y-axis against the risk level on the x-axis. The resulting line is curved (the frontier) because there is a diminishing marginal return to increased risk. The concept of an efficient frontier is that it allows investors to compare portfolios and select the one that offers the best level of return at the corresponding level of risk.

The chart below presents a series of portfolios allocated between stocks and bonds (green series). It then presents a starting 60/40 stock/bond portfolio and reducing the stocks and bonds on a pro rata basis to allocate to the balanced risk strategy previously discussed in this report, with increasing allocations to the balanced risk strategy (blue series).

Key takeaway from the efficient frontier: At any given level of risk, the portfolio integrating the balanced risk strategy offers a higher level of return which demonstrates mathematically it is the more favorable choice. But what can investors do with this information?
Before answering that question, there is one caveat to this analysis. We have analyzed using the starting basis of a 60/40 portfolio. If your situation differs materially, we would be happy to produce a customized analysis.

If 60/40 is a valid starting point, one thing investors can do is determine the level of risk they want in their portfolios. If an investor is looking to slightly lower risk, then allocating between 10% to 20% in a balanced strategy would have historically achieved that goal while also enhancing returns. If investors are looking to differentiate and materially enhance returns, a larger allocation to a balanced strategy may make sense.

Data Source: Bloomberg LP and Catalyst Capital Advisors LLC. Based on monthly return data from 12/31/1999 to 8/31/2024. Rebalanced monthly. performance does not guarantee future results.

Data Source: Bloomberg LP and Catalyst Capital Advisors LLC. Based on monthly return data from 12/31/1999 to 8/31/2024. Rebalanced monthly. performance does not guarantee future results.

Cerulli Associates conducted a survey of 200 financial advisors to understand how they were allocating to alternative investments. The sample base tended to be advisors with clients that had higher-than-average net worth.

As demonstrated in the chart below, there were some useful insights into the use of alternatives. First, with half of the advisors at 5% or less and then the average advisor allocation at over 9%, that means the half of advisors using alternatives at more than 5% were doing so in a large way (i.e., 10% or more). Second, the optimal allocation of 13% indicates that advisors generally expect to increase their allocation to alternatives over time.

For advisors looking to increase their allocation to alternatives, their goals were enhancing returns, reducing volatility, and diversifying their portfolio. The more advisors indicated that they used alts, the more they prioritized enhanced return potential. Most advisors believed that alternatives differentiated their practices allowing them to better attract high-net-worth clients and retain assets under management.

Balanced risk strategies tend to offer what advisors indicate that they are looking for when integrating alternatives into a portfolio: enhanced returns, reduced volatility, and diversification.

While the Cerulli Associates report was focused on all alternatives, it supports the analyses we found with a balanced risk strategy: a 10% to 20% allocation is enough to make a meaningful difference to your overall portfolio and that there is a good case to make in doing a larger allocation.

Disclosures:

Past performance is not a guarantee of future results. Diversification does not ensure a profit or guarantee against loss.

There is no guarantee that any investment strategy will achieve its objectives, generate profits or avoid losses.

The use of derivatives and the resulting high portfolio turnover may expose investors to additional risks that they would not be subject to if it invested directly in the securities and commodities underlying those derivatives. A hybrid strategy may experience losses that exceed those experienced by strategies that do not use futures contracts, options and hedging strategies. Investing in the commodities markets may subject the hybrid strategy to greater volatility than investments in traditional securities. There are also risks associated with the sale and purchase of forward contracts.

Definitions:

Bloomberg US Aggregate Bond Index: A market capitalization-weighted index that is designed to measure the performance of the U.S. investment grade bond market with maturities of more than one year.

Bloomberg US Treasury Index: Measures US dollar- denominated, fixed-rate, nominal debt issued by the US Treasury.

Diversification: A risk management strategy that creates a mix of various investments within a portfolio.

Futures: contracts to buy or sell a specific underlying asset at a future date.

S&P 500 Index: A market capitalization-weighted index that is used to represent the U.S. large-cap stock market/

SG CTA Trend Index: The SG CTA Trend Sub-Index is a subset of the SG CTA Index, and follows traders of trend following methodologies. The SG CTA Index is equal weighted, calculates the daily rate of return for a pool of CTAs selected from the larger managers that are open to new investment.

Volatility: A statistical measure of the dispersion of returns for a given security or market index.